Global economic growth during the second and third quarters remained strong, albeit with signs of modest tempering. The International Monetary Fund (IMF) revised its 2021 full-year guidance down modestly to 5.9%, which is still a very healthy rate of growth. They left their 2022 projection of 4.9% growth unchanged.
The US employment report released for September showed signs of slowing job creation, with fewer than 200,000 new jobs created; however, the unemployment rate declined to 4.8% as a result of an overall decline in the labor force participation rate – a measure of the eligible working population seeking work. Jobs are abundant and labor is in short supply. The latest JOLTS report (Job Opening and Labor Turnover Survey), a monthly indicator of available job openings, show yet another increase in job openings, which measured nearly 10.4 million. Today there are about 7.7 million unemployed (people actively seeking work). There is a large disconnect between labor demand and labor supply. An increase in average hourly wages is of some concern, as we believe this will be a leading indicator of embedded inflation.
We remain on alert for inflationary pressures. The US Consumer Price Index (CPI) for September indicated a year-over-year increase of 5.4% in the all-items index (which includes food and energy). Excluding food and energy, the index increased 4.0% – still a fairly high rate.
There is considerable debate as to whether the recent inflationary pressures are transitory or embedded. Previously, we were inclined to believe recent inflationary pressures were transitory, but we have shifted our opinion and now believe these pressures are embedded. The factor that swayed us is labor costs. As indicated above, the employment outlook remains challenging. Semi-skilled and unskilled laborers are hard to find, and the cost of such labor has risen sharply. We read that Bank of America Corp. is now paying entry-level branch workers $21.00 per hour. Companies across many industries are now paying entry-level employees $15.00 per hour or more. This is setting a new standard for the ”wage” component of goods and services produced. Assuming these levels stick, the cost of goods is set to increase and remain elevated.
Companies we speak with have confirmed this data. If they can find labor, they are paying up – and offering attractive perks to retain employees. Companies have two choices to absorb this elevated cost of production: 1) operate at lower profit margins, or 2) raise prices. Historically, they have selected the latter.
Recently, The Kraft Heinz Company, a business in which we are invested, warned that consumers should prepare for high food prices in the future. CEO Miguel Patricio indicated he sees inflation across the board leading to price increases. This includes raw material and labor costs.
We have observed logistical bottlenecks for the past six months, resulting in higher shipping costs. We have several investments in container shipping companies and recently in a dry bulk shipping commercial manager, all of which are well-positioned to benefit from increased shipping rates. These cost increases are likely to be passed along to consumers, further contributing to inflationary pressures.
As always, we monitor economic news both here and abroad for indications of future concerns and opportunities. We enjoy the benefit of seeing the world through the lens of our India-based associates, who often have a different perspective on issues impacting global markets.
Portfolio Update
One of the key portfolio themes from our last quarterly letter still applies:
We have continued to selectively trim our investment positions, raising more cash as valuations on both stocks and bonds remain elevated. We have taken some sizable profits this year and have sold more bonds than stocks. Interest rates remaining low has created a fevered demand for bonds, causing prices to rise to levels we believe are unsustainable. Selling into this strength has been a sensible strategy, leaving us more heavily in cash – a defensive position in the short run – and ready to step forward and make investments as opportunities arise.
We are still in a period of great uncertainty. One of the looming events that we are braced for is the inevitable tightening of monetary policy as the Fed begins tapering its monthly bond purchases and raising interest rates. We expect market volatility when this process commences.
In our firm-wide readings, we have focused on honing our business valuation practices (through McKinsey & Company’s aptly titled textbook on the subject, Valuation) and more recently the annual letter to shareholders of Berkshire Hathaway, Inc. (a fascinating compilation of business insights from Warren Buffett and Charlie Munger). Such readings inform our ongoing evaluation and selection of attractively priced investment opportunities.
During our daily research meeting we frequently quip, “remember, people run businesses.” On more than one occasion, we have invested in a mediocre business managed by an outstanding executive who has grabbed victory from the jaws of defeat. We can’t emphasize enough the importance of executive leadership. Our preference is to invest in excellent businesses run by outstanding executives. Unfortunately, those types of businesses rarely trade at a discount to intrinsic value, so we are left to select decent businesses that have the prospect of attracting outstanding leadership.
TravelCenters of America, Inc. (TA) is a classic example. TA is an attractive business based on its unique market positioning and operating leverage. We have owned it patiently for many years and through two unimpressive CEOs. Finally, beginning in late 2019, an incredibly capable executive team took control of the business. When our research team finished speaking with them, we instantly knew something had changed for the better. The stock traded around $9 at the time; today, shares are priced around $55. We believe there is substantial value left to be realized.
Our team regularly probes around the strategic focus of management teams and boards of directors. It is common for companies to have only loosely defined strategic objectives, and for executive compensation to be only casually tied to achieving those objectives. Ideally, a board demands of executives a specific and time-based strategic plan that can be easily measured and communicated to shareholders. Executive compensation plans are then structured to provide incentives based upon the attainment of those objectives. An alert board will alter executive incentives over time as the business and its strategic needs evolve.
We find it interesting that many companies are reluctant to share detailed strategic objectives with investors. Because strategy can be difficult to define and communicate, it is frequently overlooked by the analyst community. By taking time to understand a company’s strategy and evaluate its efficacy, we believe we gain a meaningful information advantage over other investors.
As we think about the critical components of a sound investment, there are many factors that we consider. People and strategy are among the most important. Our diligence process continues throughout our investment holding period, which we expect to average about five years. During that period. our research associates become quite familiar with senior management teams and the businesses they operate. Many of the decisions we make are subjective in nature, supported by empirical data. There is some amount of “art” that goes into a sound investment decision that reflects our collective judgment. We commit ourselves to improving our skills each day, and we expect that improvement to bear out in our investment results.
From Our Library
Warren Buffett frequently discusses company management, providing examples of potential red flags for investors to consider. In the late 1990s, the SEC was under considerable pressure to reconcile such issues as stock-based compensation and incentive stock-option pricing. Buffett comments generally below:
In some mergers there truly are major synergies — though oftentimes the acquirer pays too much to obtain them — but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked. (1997 Letter to Shareholders)
These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don’t produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired “earnings” or set the stage for them in the future. (1998 Letter to Shareholders)
Firm Update
As we enter the final quarter of the year, I am reminded that our people are our greatest asset. We are a group of dedicated professionals driven by a collective desire to identify great investments. Our associates have done an extraordinary job navigating the global pandemic, hardly missing a step as we moved from the office to working remotely and back. We hope your experience with the firm was seamless, despite the external challenges.
Concluding Thoughts
It’s hard to believe that 2021 is nearly over. We’ve had another very successful year and added a new associate to our India operation. We anticipate adding another US-based research analyst in 2022 as we continue to grow.
Please let us know if you have any changes in your investment objectives or financial situation that warrant adjustments to your portfolio.
Thank you for the ongoing trust and confidence you have placed in us to be prudent stewards of your capital.
Your Investment Research and Advisory Team
Global Value Investment Corp.
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